RELATED PARTY TRANSACTIONS: DECODING 'ORDINARY COURSE OF BUSINESS' AND ARM'S LENGTH TRANSACTIONS

By Awar Dan Bhimawat
LL.B. (Hons.), 2026, NLSIU Bangalore. Email: awar.bhimawat@nls.ac.in.

ABSTRACT

Related Party Transactions (RPTs) involve financial or business dealings between entities or individuals connected by a pre-existing relationship. While RPTs can improve operational efficiency by lowering transaction costs and facilitating resource sharing, they also pose significant governance risks. These risks arise when promoters or majority shareholders exploit their positions, potentially prioritizing personal gains over equitable management of company resources. In the Indian context, RPTs are regulated by the Companies Act, 2013, and SEBI (LODR) Regulations, 2015, which emphasize transparency and accountability. The exemptions provided for transactions conducted in the "ordinary course of business" and on an "arm’s length basis" create challenges due to their vague definitions and subjective interpretation. This paper critically examines how these terms are understood under Indian corporate law, supported by judicial interpretations and regulatory frameworks. It also explores their practical implications in ensuring compliance while balancing the legitimate needs of businesses. By comparing Indian standards with global practices, the study identifies gaps and provides recommendations for a more robust governance framework.

Keywords- Related Party Transactions, Ordinary Course of Business, Arm’s Length Transactions, Corporate Governance etc.

I. Introduction

Related Party Transactions are those transactions where two entities, persons or organizations with a pre-existing relationship engage in a transaction. This relationship can be a business agreement, a financial agreement, or a series of contracts. The parties on either side of the transactions might include a parent company and its subsidiaries or affiliates, employees, key shareholders, directors, or the company’s management and also involves their immediate family members.[1] RPT covers a wide range of activities, such a buying or selling of goods, providing or receiving of services, or any other financial transactions such as giving loans, offering guarantees, or investing in the securities of a related party. This may also involve appointing related parties to positions such as directors or otherwise.[2]

RPT has two potential outcomes. On one side, it provides transactional efficiency and strategic resource allocation which in turn provides the companies with an efficient mechanism for meeting their objectives.[3] This allows the businesses to enter into transactions between its affiliated entities with lower transaction costs compared to open market-based exchanges in order to transfer resources between them.[4] However, it does not come without any challenges.[5] RPT can potentially create conflicts, particularly when a person who’s say the promoter of the company or an executive, leverage their positions to enter into transactions that may align with the broader interest of the minority shareholders.[6] This opportunistic behaviour can lead to a conflicting situation where the promoters or majority shareholders may prioritise their personal gains or advantage over equitable or just management of the resources of all the stakeholders.

II. Regulatory Framework

RPTs in India are subject to various regulatory requirements to ensure transparency, fairness and governance. The Companies Act, 2013 works as the foundational legislation which provides for key guidelines and disclosure requirements for related party transactions. Section 2(76) of the Act defines “related party” which includes directors, their relatives or partners, and other entities or persons associated. Section 188 of the Act, acts as a self-regulatory framework which governs the related party transactions in India. It provides for a framework requiring approval from the board of directors through a resolution for transactions such as sale, purchase, lease, availing or rendering services or appointments involving related parties. In some case, in case a threshold is prescribed, the section also mandates a prior approval from the shareholders, barring the related parties to vote on such resolutions.

Regulation 2(1)(zb) of SEBI (LODR) Regulations, 2015 defines “related party” as entities or persons defined under section 2(76) of the Companies Act, 2013, including definitions as per the Accounting Standard AS-18 and Ind AS-24. It also provides that any person or entity in the promoter group holding more than 20% in the entity is deemed a related party. “Related Party Transactions” are defined under regulation 23 as transfer of resources, services, or obligations between a listed entity and a “related party” with “materiality” defined as transaction exceeding 10% of the annual consolidated turnover. It also prescribes mandatory shareholder approval for material transactions, where the “related party” is barred, from voting on such resolutions. The regulations also mandate annual disclosures. These regulations aim at ensuring transparency and accountability in transactions between related parties.

However, the Act provides that the transactions in the ordinary course of business and conducted at arm’s length are exempt. Fourth proviso to section 188(1) of the companies Act, 2013 provides that transactions which fall under section 188(1))(a) to (g) are exempted from its applicability given that the transactions are conducted in the “ordinary course of business” and on an “arm’s length basis”. An “arm’s length transaction” is defined as one conducted between related parties as if they were unrelated which helps ensure that there is no conflict of interest. However, problem arises as firstly, the definition is subjective and secondly it assumes that there exists a transaction which is comparable between unrelated parties, which may not always be the case. Prior approval becomes mandatory only when transactions are not on an arm’s length basis or fall outside the ordinary course of business.

RPTs inherently raises significant governance red flags. These transactions aren’t just routine transactions for the purposes of efficient resource allocation and management, they are also potential breeding grounds for financial manipulations.[7] The issue here is that the promoter may make the transaction look good on paper but actually hidden within, actually serve their own interests. One major concern is that they often raise the concern of breaching the principle of “arm’s length pricing” and “ordinary course of business”.[8]

RPT in India have become norm instead of being an exceptional method to allocate resources. Research by Srinivasan in his book conducted in 2013 highlighted that over 80% of the Indian companies actively engage in Related Party transactions to meet their economic objectives.[9] However, this does not imply that RPTs are always used as a method to divert funds in promoter’s benefit. RPTs also serve operational efficiency by reducing transaction costs. Restricting such transactions can actually work against achieving the goal of maximizing shareholder value.[10] For example, in case the company functions in space where there is inherent lack of institutional support, RPTs can help achieve better asset utilization and lower transaction costs.[11] Another way is that it allows the holding company to share risks by redistributing income and reallocating funds between affiliates when needed, which provides flexibility and resilience in financial management.[12]

Indian investors and creditors recognize this tendency among group affiliates companies to divert financial resources to less efficient group firms or provide inter corporate loans when they struggled to raise capital.[13] Such practice not only diminishes the value of the company in question but also results in the company’s bankruptcy and eventual collapse.[14] A notable example would be the downfall of Satyam computers where the promoters under the guise of RPTs committed the acts of fraud and concealing financial irregularities.[15]

The Companies Act, 2013 and SEBI’s (LODR) regulations prescribes that Related Party Transactions must occur on “arm’s length” basis, which requires both board and shareholder approval unless the transaction are part of the “ordinary course of business”. However, both the Act and regulations only vaguely define the terms “arm’s length transaction” and “ordinary course of business.” While section 92C of the income Tax Act, 1961 does provide the method to determine arm’s length pricing, the exact calculation depends on the nature and the type of transactions, which can vary across firms and industries. The Lack of clarity in the Companies Act, 2013 on these terms makes it difficult for the auditors tasked with reviewing RPTs increasing the risk of oversight or misjudgment. In this paper I will analyze how the terms “ordinary course of business” and “arm’s length transactions” are interpreted under Indian corporate law and compare with international standard.

III. Interpreting ‘Ordinary Course of Business’

In common parlance, “ordinary course of business” means those transactions which are conducted as part of the company’s regular day to day operations. These are generally in line with the company’s business objectives and are aligned with its charter documents. Black’s law dictionary defines “ordinary course of business” as the “normal routine in managing trade or business.” The Law Dictionary describes it as “those activities that are necessary and normal.” Despite the terms widespread use in laws and agreements that the company’s use all the time, the phrase’s interpretation continues to be debated and determining whether a transaction qualifies as “ordinary course of business” depends on case-to-case basis.

The Companies Act, 2013 (the “Act”) uses the term “ordinary course of business” under various provisions related to financial assistance and related Party Transactions. Section 67(2) provides that companies providing financial assistance are prohibited from giving it to anyone for the purchase or subscription of their shares. However, section 67(3) creates an exception for banking companies which allows them to lend money as part of their regular business operations. In the context of Related party transactions, section 188(1) allows the companies to not require board’s approval for transactions entered into related parties, provided that these transactions are in the “ordinary course of business” a conducted on “arm’s length basis.”

To determine whether a transaction or an activity is carried out by the business in its “ordinary course of business”, ICSI in its guidance note highlighted certain factors that can be taken into consideration such as looking into their MOA and see whether the activity is covered under aligns with the objectives of the company and whether it furthers the business’s objectives.[16] The guidance note also points out that it will be relevant to look whether the activity is routine or customary for that particular business, such as advertising or employee training and whether it occurs frequently or repetitively.[17] Additionally, whether the income derived from such transaction or activity is recorded as business income in the company’s accounts and if similar transactions are common within the industry.[18] Other considerations also include the financial scale of the activity in relation to the company’s overall operation along with the revenue that the transaction or the activity generated, and the resources committed to the activity by the company.[19]

In the case of CIT v. Motilal Haribhai spinning and Weaving Co. Ltd[20], the court made a reference to the judgement of Oriental Investment Co. Ltd. v. Commissioner of Income Tax [21]where the court observed that merely because the company’s memorandum includes the object of dealing in investment or shares, does not automatically imply that the company deals in shares and is part of their “ordinary course of business.” However, the court observed that it can serve as one of the relevant factors which if combined with other circumstances to assess the nature of the company’s activities. Tribunal in the case noted that while MOA is not a conclusive factor in determining whether certain activity constitute a business, they do provide a significant insight into the intent of the objectives of the company. The tribunal observed that frequency of an activity might indicate a continuous and organized business organization, however in the present case the company was its first year of its operation and that the activity in question could not be classified a continuous and organized business activity. The tribunal also noted that not all transaction associated with or connected to a business can be considered incidental to its operations and that such transaction must form an integral part of the business.

The court in the case of Seksaria Biswan Sugar Factory Ltd. vs Commissioner of Income-Tax[22] dealt with the case where the assessee company primarily engaged in sugar manufacturing but advanced a loan of Rupees Six Lakh to a firm related to its managing agents. The court observed that having money lending as an object in the MOA does not make such a transaction part of the ordinary course of business, especially since they had no prior history of money lending. The court also observed that since this was a one-off act unrelated to company’s usual operations, it did not qualify to be exempted.

The court in the case of Somanath Baraman and others v. Raja S. V. Jagannatha Rao the court observed that “Such stray or casual act cannot be called an act done in the ordinary course of business. (See). The habit system and continuity that is required to satisfy the test of regular or ordinary course of business in this case.” This implies that the activity in question must be habitual and systematic and continuous and that an isolated act and infrequent transaction cannot be “ordinary course of business.”

The court in the case of Kalapnath Singh v. Surajpal Singh[23] observed that the term “ordinary course of business is not defined under any of the Acts clearly but highlighted that the expression does indicate that “uniformity of dealing, and a certain degree of routine in business practice.” Similarly in the case of Peddi Virayya vs Doppalapudi Subba Rao and Anr [24] the court held that “The expression "in the ordinary course of business" is susceptible of one meaning viz., that there should be a series of transactions as distinguished from one transaction. And that a A stray transaction may not be said to constitute an ordinary course of business.” Furthermore, the court in the case of State of M.P. vs Bengal Nagpur Cotton Mills Ltd.[25] the court observed the difference between activities carried out continuously and activities carried out with an intention of earning profit irrespective whether the activity is generating profit or not.

The court in the case of A. Ebrahim And Company vs The State of Bombay[26] established the test of “reasonable connection to business”. This test requires the court or the auditor to look into the circumstances and facts to ascertain if the sale or the transaction has a resalable connection to the dealer’s regular business activities. A transaction is in course of business it its logically and relevantly aligned with the nature of the dealer’s business and that infrequency of the transactions does not automatically precludes it from being in the ordinary course of business. Overall, the circumstance around the transaction has to be taken into account to determine whether the transaction is in the ordinary course of business.

In Deputy Commissioner of Income Tax vs. Oscar Investments Limited[27], the Income Tax Appellate Tribunal reiterated that the company’s MOA is not conclusive in determining whether an activity constitutes a part of ordinary course of the business. In addition to that, other factors such as the company’s pattern of capital allocation, asset utilization, and income composition over the last few years are important in determining it.

The courts have interpreted “ordinary course of business” as activities that are routine systematic and which align with a company’s regular operations and objectives. While MOA does provide at starting line, it is not the end line as in order to determine that, one has to focus on whether the transaction exhibits continuity and forms an integral part of the business. Other factors like the transaction’s frequency, its financial impact, industry norms, and alignment with the company’s business objectives are all taken into account when making this determination.

IV. Interpreting ‘arm’s length Basis’

Fourth Proviso to section 188(1) of the Companies Act, 2013 states that certain transactions which are conducted on “arm’s length basis” are exempted from the purview of the procedural requirement of section 188. However, the problem arises that the Act does not define these terms which makes it difficult to catch these transactions. The term has been defined under explanation (b) to section 188(1) as “a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest”. Despite the explanation the Acts lacks any further explanation in order to determine “arm’s length price” in practice. The lack of clarity often leads to the promoters of the companies to bypass the need for shareholder or broad approval mandated under section 188(1) by using vague dentition as loopholes. However, arm’s length price is only one of the factors in determining arm’s length transaction.

The guide to ISCI gives an example to help understand when a transaction would be at arm’s length standard. Consider an example where a company engages in a sale of good with two parties, one related and one unrelated.[28] The company charges 100 rupees to both of them and would appear to be at an arm’s length is taken on the basis of the value of the transaction.[29] However, say if the unrelated party is given a credit period of 15 days and on the other hand the related party gets the credit period of 6 months, in that case the said transaction would not qualify as being at arm’s length. Thus, the transaction has to be looked at its entirety and not just the price.[30]

In the famous case of Madhu Ashok Kapur & Ors. V. Rana Kapoor[31], in which the appointment of Managing Director was questioned and one of the arguments raised was that it was not at arm’s length basis and that it violated governance norms. However, the court adopted a liberal interpretation and emphasised on fairness of the transaction instead of rigid procedure. The court emphasised that an arm’s length Transaction must reflect market standards in order to ensure that the transaction is fair and impartial. The court in this case looked at the terms and conditions of appointment and instead of strictly adhering to the procedure prescribed, the court looked whether the appointment was in consistency with the industry norms and free from undue influence. Based on the above indicators, the court held that the appointment was indeed at an arm’s length.

The court in the case of A.K. Roy v. Voltas Ltd.[32] observed that in order to determine whether the transaction is at arm’s length basis, it should be free form extra commercial consideration such as favouritism or any other personal relationship. One indicator of that would be selling the goods at especially low price to a favoured buyer. However, the court noted that just because the agreement stipulates certain advantages, this does not mean that the transaction is not at arm’s length, as long as they are able to show that the terms are fair, reasonable and negotiated commercially. The court also observed that volume of the transaction is not relevant.

The court in the case of Iljin Automotive Private Ltd v. The Asst. Commissioner of Income-tax[33] observed that in order to understand the meaning of “arm’s length price” one has to ask the question: “what would the price have been if the transaction had occurred between two unrelated parties under similar circumstances?” The court emphasised that in order to determine arm’s length price requires looking into factors such as nature of product and the terms and conditions of the transaction which helps ensure that the price reflects what independent parties would agree upon in comparable situation.

The case of C.I.T. v. Nimbus Communication Ltd.[34], A.C.I.T. v. W. S. Industries (India) Ltd[35], deals with the situation where it appears that a preferential treatment is given to a related party which raises the question whether the transaction truly qualifies at “arm’s length.” In this case, a corporate guarantee was extended to an associate enterprise, without having to charge a fee, but the court considered it to be a matter of commercially expedient transaction when undertaken to support the business interests of the enterprise. The court here suggested the prudent businessperson’s perspective.

The concept of “arm’s length basis” is one of the most important methods to ensure that the transactions are fair in its dealing but have often lacked clarity in tis legislative definitions. However, the court have consistently emphasized that such transaction must reflect terms that would apply between unrelated parties under similar circumstances. The court also emphasized that the transaction should be fair, consistent with the market and need not necessarily stick to rigid procedure. Even in the transactions which are favorable to an affiliate party, the transaction must demonstrate commercial justification. Ultimately the discretion of the court applies, and it should focus more on substance over form.

V. Conclusion

RPTs are an essential part of corporate operations and governance offering benefits such as efficiency and resource allocation and cost efficiency. The Companies Act requires that such transactions be disclosed in order to ensure transparency. However, the problem arises due to the exception that if the transactions fall under the terms “ordinary course of business” and conducted at an “arm’s length basis”, the obligation to report or taking approval of such transactions is not required. Furthermore, the problems get aggravated since the acts and regulations do not provide a clear set of definition which leaves potential for misuse and bypassing the requirements. Judicial interpretations have clarified that for a transaction to be considered at arm's length, it must reflect market standards, be fair, and not influenced by personal relationships or conflicts of interest. The focus should always be on the substance of the transaction rather than its form. While RPTs can be beneficial for business operations, they must be conducted transparently and ethically to avoid exploitation. To ensure RPTs serve their intended purpose without undermining governance, there is a need for clearer definitions and stronger regulatory oversight. Ultimately, robust regulation is essential to protect stakeholders and ensure that these transactions align with the company's long-term goals and fairness.

*******

* LL.B. (Hons.) Batch of 2026, NLSIU Bangalore. Email: awar.bhimawat@nls.ac.in.

[1] Padmini Srinivasan, 'WORKING PAPER NO: 402 An Analysis of Related-Party Transactions in India' (IIM Bangalore , September 2013) <https://www.iimb.ac.in/sites/default/files/2018-07/WP_No._402_0.pdf> accessed 9 December 2024.

[2] Ibid.

[3] Ibid.

[4] Abdul Rasheed and others, 'Promoter Ownership, Related Party Transactions and Firm Performance: A Study Among Select Companies in India' [2019] 8(3) FIIB Business Review 1-13

[5] Ibid.

[6] Ibid.

[7] Abdul Rasheed and others, 'Related party transactions and audit risk' [2021] 8(3) Cogent Business & Management 1-17.

[8] Ibid.

[9] Padmini Srinivasan, 'WORKING PAPER NO: 402 An Analysis of Related-Party Transactions in India' (IIM Bangalore , September 2013) <https://www.iimb.ac.in/sites/default/files/2018-07/WP_No._402_0.pdf> accessed 9 December 2024.

[10] Ibid.

[11] Sharon Belenzon and others, 'Innovation in Business Groups' [2007] S&P Global Market Intelligence 5.

[12] Raymond Fisman and others, 'Trading Favors within Chinese Business Groups' [2010] 100(2) American Economic Review 429-433.

[13] Radhakrishnan Gopalan and others, 'Affiliated Firms and Financial Support: Evidence from Indian Business Groups' [2006] 86(3) Journal of Financial Economics, Forthcoming 759–795

[14] Peng, W.Q and others, ‘Tunnelling or Propping: Evidence from connected transactions in China’ [2006] 17 . Journal of Corporate Finance 306–325.

[15] Ibid.

[16] 'GUIDANCE NOTE ON RELATED PARTY TRANSACTIONS' (ICSI) <https://www.icsi.edu/media/webmodules/publications/A20ChapterPages.pdf> accessed 9 December 2024.

[17] Ibid.

[18] Ibid.

[19] Ibid.

[20] MANU/GJ/0014/1977

[21] MANU/SC/0059/1957

[22] (1950)52BOMLR91

[23] Kalapnath Singh vs. Surajpal Singh and Ors. (14.09.1948 - ALLHC) : MANU/UP/0205/1948

[24] AIR 1959 AP 647.

[25] [1960] 12 STC 333 (MP).

[26] [1962] 13 STC 877(BOM).

[27] [2006]98ITD339(MUM)

[28] 'GUIDANCE NOTE ON RELATED PARTY TRANSACTIONS' (ICSI) <https://www.icsi.edu/media/webmodules/publications/A20ChapterPages.pdf> accessed 9 December 2024.

[29] Ibid.

[30] Ibid.

[31] MANU/MH/1038/2015.

[32] 1973 AIR 225.

[33] MANU/IX/0171/2011

[34] (2014) 30 ITR 349.

[35] (2011) 9 ITR 596.